Rising Bond Defaults Are Good

The rate of missed debt payments for companies with risky credit ratings is nearing levels last seen during the Great Depression. It sounds like another reason to fear that, with the unemployment rate clearing 10%, the Great Recession is far from over.

But that would be a misreading of the statistics, says Martin Fridson, head of Fridson Investment Advisors. More defaults certainly signal trouble, as defaults are usually the first step on the path to bankruptcy. The default rate, however, looks backward, counting the percentage of junk-rated companies that have missed interest payments over the previous 12 months. Because it looks through the rearview mirror, the rate keeps climbing higher, even though actual defaults have ebbed.

The rate inched up to 13.4% in October, according to a report from
Moody's
Investors Service on Thursday. Standard & Poor's, a rival rating agency, put it at 11.3%. Both say the rate could move slightly higher this year, as the months with low defaults from 2008 drop from the 12-month survey. By Moody's count just eight companies missed debt payments in October, the lowest monthly tally all year and that number has been dropping since summer.

Confusion over the rate has led some to wonder why the risk premium for junk bonds has fallen despite higher default rates. Fridson points to another way of looking at it. Using Moody's data, he created monthly averages by quarter: 29.7 in the first; 27.7 in the second; and 16.7 in the third.

"The correct story," he wrote in an email, "is that spreads have narrowed appropriately as defaults have tapered off."

The rating agencies expect the rate to begin a steep drop next year, which also means fewer companies will land in bankruptcy. Falling borrowing costs and the ability of companies to refinance in buoyant bond markets led S&P to cut its default-rate forecast in half last month. Those companies with heavy debt burdens now stand a better chance of survival, which means more should stick around to pay interest payments on their bonds. It now expects a 6.9% default rate by September of next year. (see "The Failing Failure Rate").

This downturn in the credit cycle has already resulted in 10 of the 20 largest defaults since 1980, according to CreditSights. The largest in this batch:
Lehman Brothers
, Washington Mutual, General Motors Corp. and Chrysler.